Zepp Health Corp: An overlooked Chinese investment case?
Opdateret: 3. maj
I don't know how many people knows Zepp Health, but it is a Chinese maker of smart wearables. They are among the world's leading makers of smart wearables, as they make the ones of Xiaomi, and Xiaomi currently has more than a 9 % market share of the sector. Even more interestingly is that Zepp Health also has their own branded smart watches, which could be a future growth catalyst.
This is not a financial advice. I am not a financial advisor and I only do these post in order to do my own analysis and elaborate about my decisions, especially for my copiers and followers. If you consider investing in any of the ideas I present, you should do your own research or contact a professional financial advisor, as all investing comes with a risk of losing money. You are also more than welcome to copy me.
This analysis will be a bit different from what you are used to read in my blog. Pirelli has only been listed on the stock exchange since 2017, and because of that, I believe it is better to do a discounted cash flow analysis. So instead of using the principles I have learned from my Phil Town workshop, I use the principles I have learned from the GOAT academy. I should also mention that most of the numbers I use in this analysis is from Finbox, which I believe is a great tool to get different numbers from various companies.
For full disclosure, I should mention that I have add Zepp to my portfolio since I first wrote my analysis. If you are interesting in copying me, you can see how to do so here, and if you want to see my current portfolio, you can do so by subscribing here and search for my user name Glenndk.
Zepp Health was founded in China in late 2013 and was then known as Huami Corporation. In 2017 they entered into a strategic cooperation with Xiaomi to develop their wearable products. This agreement got extended in 2020 for three years and will end in 2023. Xiaomi owns 14,2 % of the shares in Zepp Health and the sales of Xiaomi products have contributed to most of the revenue in Zepp Health with 66,9 % in 2018, 72,2 % in 2019 and 69,0 % in 2020. Besides making smart wearables, Zepp Health also makes smart scales, hearables, and home fitness equipment. There are a lot of potential as well as synergies in these areas, which could make Zepp Health even more compelling in the future. It is hard to determine a moat for Zepp Health, as they most known products are made for Xiaomi, while their own brands Amazfit and Zepp are lesser-known brands. Nevertheless, despite the lack of a current obvious moat, I feel like they could develop one on in the future, and it does give me confidence in the company that they were able to ship 45,7 million unites of smart wearable devices in 2020.
Their CEO is Wang Huang. He is also the founder of the company, which is something I usually like. I find that founders are usually more motivated in growing the business rather than their wallet. He is a graduate of the Department of Physics of the University of Science and Technology of China with a major in microelectronics. He is known as a serial entrepreneur that has created a Linux development board, a PDF reader, and a tablet. He is even more known for creating the Mi Smart Brand, which led to the cooperation with Xiaomi. It is hard to find much information about Wang Huang as a CEO, but his entrepreneurial spirit continues to shine, latest with the development of their own operating system called Zepp OS. Once again, Wang Huang thought out of the box and created an operating system that should reduce operational power consumption by 65 % and increase battery life by 190 %, which is something consumers will appreciate. Under his leadership Zepp Health became the fourth largest smartwatch vendor by shipments in the world in 2021 and has become the top smart watch vendor in markets such as Brazil, Russia, and Spain. Despite me not knowing much about Wang Huang, his track record makes me comfortable in him being the right person to drive Zepp Health forward.
I believe that Zepp Health doesn't have a defined moat for the time being, but I feel very confident in the innovative nature of the CEO, which in my opinion makes up for the lacking moat. Later I will do a discounted cash flow model to calculate a price for Zepp Health but before I do so, let us just have a look at some key financial metrics.
Down below we see some key financial metrics from the last 3 years. Looking at the numbers it is obvious that Zepp Health had bad years in 2020 and 2021 compared to 2019. Their gross profit margin still looks fine despite it decreasing a little from 2019, but their operating margin did suffer a lot. It isn't surprising though, as the pandemic naturally hurt a company such as Zepp Health. The lockdown in China halted production, and at the same time it hurt consumer demands in both 2020 and 2021, while supply chain shortages in 2021 further hurt the company. Looking at 2019, it looks better but the question is if Zepp Health will get back to that level.
Before we continue to the discounted cashflow model, I would like to investigate the risks and potential of Zepp Health. There are several risks that could hurt Zepp Health moving forwards. Like with most other companies right now the price of raw materials and freight. If the prices continue to rise, it will hurt their margins. Another risk that hurt pretty much every company is the global supply chain shortages. In their latest quarterly conference call, they mentioned that "supply chain issues dampened our third quarter results in a number of ways". While both risks might be short-term risks, they are still very much alive and is expected to continue into the next year. The same can be said with the pandemic. New variants might result in more lockdowns. As I write this several European countries are introducing restrictions, and from the 2020 numbers, we see how a company such as Zepp Health performs during a pandemic. Their dependence on Xiaomi is also a risk. Last year 69 % if their revenue was generated through their cooperation with Xiaomi. And while nothing suggests that this cooperation will end, Xiaomi can terminate the agreement if Zepp Health fails to meet various requirements. Furthermore, Xiaomi has the option to develop by themselves or engage other companies to develop similar or competing products, if such companies can offer better terms. Finally, Zepp Health is a Chinese company that is listed on the U.S. stock exchange. Lately, there has been a lot of talk about delisting of Chinese companies due to the holding foreign companies accountable act, or even to some of the executive orders made by former president Donald Trump, which blacklisted Xiaomi. Xiaomi was later removed from the blacklist, and luckily it seems like that the SEC and CSRC are working on solution on the audit papers, but it is certainly a risk you should be willing to take.
However, there are also a lot of potential for Zepp Health moving forward. The sales of their own branded smartwatches are growing. In Southeast Asia their own branded smartwatches are now numbers two in sales, their shipment volume to the U.S more than doubled in the third quarter and they are also making progress in larger European markets. Their shipments to Germany increased by 150 % in the third quarter 2021, while they are now also the number one ranked smartwatch in Italy. They also try to heighten their brand awareness in China by changing the name from Aamzfit to Yuewo (which means rise up and surpass ourselves). In 2021 their own branded smartwatch contributed to 46,5 % of their revenue and management believes that it may go to 50 % in 2022. It is important, as they have higher margins on their own branded smartwatches than they do on the Xiaomi smartwatches. Their other products may also lead to further growth in the future. Their Amazfir PowerBuds Pro were named as a CES 2022 Innovation Awards Honoree, and are not your normal earbuds, they also work as biosensor, heart rate monitoring and hearing protection. We only have little data on Zepp Health but looking at ROIC, even if you include the last two years. Finally, the management has approved a $20 million share repurchase program, which demonstrates the confidence they have in the company moving forward. In the next paragraphs I will go through my calculations to find the intrinsic value of Zepp.
I have now investigated the financials, risks, and potential of Zepp Health. I will now look at the price by doing a discounted cash flow model. To do so I will need some numbers that you can see below. I found the numbers at Finbox. However, the perpetuity growth rate and the discount rate are numbers I have come up with myself. The reason I chose 5 % as perpetuity growth rate is that it is usually a between the historical inflation rate of 2-3% and historical GDP growth of 4-5%. I decided to go with a higher option. The chosen discount rate of 12% because it is usually between 9-12%, and due to the current market conditions, I decided to go with the highest one. Remember that all the numbers made in these calculations are in millions.
I also need to determine how much EBIT, Depreciation & Amortization and Net Working Capital will evolve over the next couple of years. I believe that Zepp Health will grow their EBIT with 60 % in average year over year in the next 5 years. These numbers are in line with the analysts' expectations at Finbox. I believe that Depreciation & Amortization will grow with 20 % year over year moving forward. Finally, we have the Net Working Capital. I believe that the Net Working Capital will stay relatively flat moving forward These numbers might seem rather high, but they are in line with the analysts' expectations. Unfortunately, I cannot find a smart way to share the whole sheets with calculations in here, but I gave you the numbers, so you can do it yourself. However, once I my calculations, I found that the intrinsic value of Zepp to be $8,4. I also made some calculations on the 2019 numbers, with an EBIT growth of 30 %, Depreciation & Amortization growth of 20 % and Net Working Capital growth of 15 % and came up with an intrinsic value of $27,4.
Having investigated Zepp Health, I find the company to be interesting. The sector is expected to grow by a 16 % CAGR until 2025, which is why it would be interesting to have some exposure to the sector. While Zepp Health is still building their own brands, and doesn't have a moat as it looks now, I love the innovation of the management. Latest seen by their OS system which will give Zepp Health smartwatches a competitive advantage if it continues to evolve. There are some risks if you invest in a company like Zepp Health, especially the tensions between the U.S and China could mean the negative sentiment towards Chinese equities could continue longer than expected. At the same time, we will probably also see higher costs on raw materials and freight going into 2022, and the supply chain shortages will probably continue too. Nevertheless, if you look at the valuations on Chinese equities compares to American equities, it seems like China is the place to be, unless you are afraid of the delisting. I believe the price of Zepp Health is very compelling at these levels, and I will probably add a position to the portfolio.
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